Fund Manager's View

'Value strategy underperforms in momentum phases'

Mrinal Singh, fields questions about ICICI Pru Value Discovery Fund and explains why the fund remains promising

'Value strategy underperforms in momentum phases'

What is the reason for the short-term underperformance of the Value Discovery fund?
In line with the value-investing principles that we have practised for almost 13 years, we give priority to valuations, earnings, business quality and financial strength of a company. Whenever we find that there is a disconnect between price and value, we tend to become a bit more cautious about investing in it. We always prefer businesses where the risk-reward ratio is favourable.

If you look back, you will find that there have been instances where the markets have run ahead of the data, which typically are momentum phases. In such phases, we have underperformed. But if you look at our historical performance, there is nothing to worry about because subsequently we more than make up for our underperformance and this is the strength of value investing.

Why do value stocks underperform in the momentum phase?
Momentum basically means prices running ahead of the data. There are two possible scenarios after this: either the data catch up or there could be a time correction. As value investors, we need to be very conscious of the data.

When we filter through things, there is a set of stocks that come up. Very often, we find our checkboxes ticked in a zone which has out-of-favour stocks or sectors. Such stocks have bouts of underperformance periodically but when their value is unlocked, the performance improves substantially. We have seen in the past that it more than makes up for the short-term underperformance.

This is why we tend to strongly push or propagate the idea of having a long horizon because that is how value investing works. You will require patience because there are bouts of underperformance and stronger performance. Long-term returns are an outcome of following this strategy over an extended period of time.

What challenges do you face with the sharp increase in AUM? Is it by any way contributing to the fund's underperformance?
A huge part of the AUM growth that you have seen in the last seven years is due to successful stock investing. The stocks themselves have grown in value and this reflects on the NAV. Net inflows have been a major contributor in the last one and a half years.

It is important to note here that we are not bound by market cap. Neither do we choose to invest along with the market. We tend to buy stocks when they are going through a difficult time. Our ability to scale up is far more as compared to some other strategies which have to stick to a defined mandate in terms of the market cap or buy along with the market.

Having said that, the number one challenge is not the size, it is the market itself because there can be phases where the market is in a zone, in terms of valuation, where opportunities which fulfil the criteria of value investing are not many.

I don't think that size is a challenge till now. We are still able to manage pretty much the money that we have. The issue is that the opportunities in the current phase of the market seem to have contracted substantially from the value-investing perspective.

The fund's portfolio has substantially shifted towards large-caps. In the short term, the fund has also been underperforming in the large-cap category. Why is that so?
From a risk-reward perspective, large caps are a better place to be in. The most important thing is that a lot of our mid-cap investments have turned into large-caps as they gained in value. Meanwhile, mid-caps have done substantially better than large-caps and hence it's time for large caps to catch up.

We are in a phase where a substantial shift of domestic savings is transforming from physical assets to financial assets. This has resulted in the markets moving up, taking into account a decent bit of expected earnings growth. But our choice of stocks has been predominantly in the out-of-favour zone, where the valuations are more comfortable. And in the last one and a half years or so we haven't had a phase where value unlocking has broadly happened in that segment.

Also, we haven't seen a full cycle in the current phase. While evaluating a fund's performance, one has to take into account the complete cycle, which includes three to four phases that the market has to offer. That's the reason why we tell investors to look at historical performance while making their investment decisions.

In comparison to the benchmark, you are currently overweight on technology. Why are you so optimistic about it?
If you look at our overweight positions, there are predominantly three sectors: technology, pharma and industrials. This is the outcome of three specific stocks, one in each sector, rather than the sector itself. But we pick businesses rather than sectors. Obviously, businesses do belong to a sector and when you create a position because you like the business and the price, it creates an overweight position in that sector.

There are challenges in the technology space. It is not that these companies are not capable of meeting the challenges. The only thing is that there is the traditional part of business which is struggling for growth and it is a big part of revenue. And the new part of the business is galloping at a very fast pace but it is a small part of the business. We have evaluated the strategies that these individual companies are pursuing. Accordingly, we have deployed investments in zones where we think the strategies have the best possibility of succeeding.

Also, this has to couple with the right price that we pay for our investments and the kinds of checks that we would like to have. This framework applies not only to technology but also to every investment that we pursue.

We have seen such phases when particular sectors have become out of favour in the past. Technology sector is most susceptible to this phenomena. We have to intelligently pick the names which will sustain for the long term.

In one of your earlier interviews, in 2015, you regretted missing the rally in FMCG stocks. You are still underweight on FMCG. What is your strategy this time?
If you look at the golden phase of FMCG stocks in 2008-09 all the way till 2013, we didn't have any FMCG company during this period. We picked them up for a brief period in 2014 but we still managed to get very good returns.

The key part of value investing philosophy is to focus on the price. We have managed to invest in the best-performing sectors and if they don't fulfil our valuation criteria, we have still managed to get good returns by buying what we think is cheap and doing that consistently. So, it's not that we need to own a stock which we believe could be steeply priced.

I would like to add that it doesn't mean FMCG stocks are something which I won't own at all. Obviously, I would evaluate opportunities and if I find FMCG a better opportunity, I will own it.

Is there any particular sector where you see a lot of value investment opportunity? What sector would you like to avoid?
We have consistently stayed away from real estate for a long period of time. Industrials, along with power look like a good place to place your bets. The valuations are reasonable in power and the risk-reward is favourable in select pharma and tech stocks - more in pharma as of now. This is also reflected in our portfolio allocations.

What is the reason for staying away from real estate? Is it because of the new regulations?
The issue with the real estate sector is that we have struggled to make sense of some of their balance sheets. In highly leveraged businesses, we, as equity investors, have also struggled to figure out what is there left for us. By nature, real-estate companies are highly leveraged businesses and most of the products that they manufacture and sell are mortgaged to lenders. They have the first right followed by the government and then followed by us. For the revenue stream that real estate businesses deliver, you will see that the profits are meagre. And as equity investors, we are more concerned about profits.

How would you reassure investors of your fund's potential?
For our customers, what is important to see is if our strategy has the capability to sail through this phase of underperformance and, more than that, compensate for it in the future. This is where having a track record of 13 years through market phases is very helpful. We would urge our investors to consider looking at our performance data through those phases and even across a very long phase of flattish markets.

I would also like investors to consider the SIP returns that we have generated for them over a longer time horizon, say five or 10 years, and then make an informed decision about how they want to proceed with their investments.

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